Profits

Dr. Rogge is Dean and Professor of Economics at Wabash College, Crawfordsville, Indiana. This article is from an address before the Na­tional Association of Manufacturers’ Clergy-Industry Relations Committee and Clerical Advisory Council.

By any measure one can conceivably use, profits have been shrinking in recent years. Profits after taxes in 1941 constituted 9 per cent of the national income’ in 1961 they constituted 5 + per cent of the national income. Profits as a percentage of dollar sales av­eraged 5½ per cent in the period 1947-1949; now they are averag­ing 21/2 to 31/2. Profits as a per­centage of net worth averaged 11 to 13 in the period 1947-1949; now they are averaging 6 per cent to 7.

Are Profits Now Too High or Too Low?

Can we deduce from this infor­mation that profits are now too low or that they were once too high and are now just right? This is a complex question and calls for a complex and serious answer.

The first problem is to define what is meant by "too high" and too low. Unfortunately, total dollar figures tell us almost nothin­g; as a matter of fact, neither do percentage figures of the kind I have given above. I am no more justified in using those figures to prove that profits are now too low than a trade union economist would be in using them to prove that profits were once too high.

The percentage share of profits in the national income of a coun­try is largely determined by the relative abundance or scarcity of entrepreneurial capital and talent. In a country where capital is scarce and business leadership talent is in short supply, profits will and must command a larger share of the national income than in a country where both capital and talent are relatively abundant. The failure to recognize this fact is the single most important de­terrent to economic growth in the underdeveloped countries of the world today. The governments of those countries, inspired in part by the anti-profits bias of both the socialists and the modern lib­erals, have tried to keep profit levels low, or have punished or nationalized the high-profit firms. In doing so, they have dried up the wellspring of all economic de­velopment: vigorous, aggressive entrepreneurship.

It follows as well that as an economy matures and becomes relatively better blessed with capi­tal and leadership, the percentage share of the national income rep­resented by profits will decline. Thus, the figures I presented above do not necessarily prove that profits are now too low.

The Concept of "Normal" Profits

So let us abandon our inquiry into total figures. Where can we turn? One technique of explana­tion frequently employed is that of evaluating profit figures for the individual firm. If, for a given firm or industry, profits as a per­centage return on sales or invest­ment are found to be significantly higher than for other firms or in­dustries, profits are said then to be "too high"; if much lower than for other firms or industries, they are said to be "too low."

This technique seems on the surface to be a valid one, and its validity is apparently attested to by the fact that even businessmen use it when they want to prove that their firms or industries are in need of help or are suffering under special handicaps.

One assumption here is that normal profits (as determined by the statistical average of all prof­its) are the right or "just" profits and that profits above or below normal are thus "too high" or "too low."

This approach is often used by trade unions to show that a given group of firms has been making abnormally large profits and thus can and should pay higher wages.

It is extremely unfortunate that this point of view on profits has received such wide acceptance in all groups in our society. It im­plies that businesses should be permitted (perhaps even assisted) to make a "normal" or "fair" profit, but become suspect once they earn more than this statisti­cal norm.

This approach rests on a serious misunderstanding of the function of profits and losses in a free mar­ket economy. It is true that, in the long run, and in a competitive market, each firm will be making profits no more and no less than it could make in alternative activi­ties. This is true because if the typical firm in the industry were making higher than normal prof­its, other firms would enter the industry and profits would be driven down. If the typical firm were making lower than normal profits, some firms would leave the industry and profits for those remaining would rise. Thus in the long run profits do tend to be at the so-called normal or average level.

However, at a given moment of time in a changing, dynamic econ­omy, few firms or industries will be in this long-run equilibrium position. Most will be in the proc­ess of making adjustments to the changing circumstances. Thus in some industries, profits will be well above normal, and in others, profits will be well below normal.

It is this fact which leads the firms involved to make the adjust­ments called for in the service of consumers. The abnormally high profits in some industries are the signal that consumers are calling for more firms to enter those in­dustries. The below normal profits or outright losses in other indus­tries are the signal that consumers are calling for some firms to get out.

The importance of this signal system can be illustrated by the life-history of the ball-point pen. When Reynolds produced the first ball-point pen, he sold it for around $12.95. It is doubtful if, even then, production and dis­tribution costs were as much as one-fourth of the selling price. By any measure known to man, Rey­nolds was receiving abnormally high profits. However, the signal went out loud and clear and soon every pen company had its ball­point pens and new firms entered the field almost daily. Within a short period of time, the price of the pens had dropped below five dollars. Now I am writing this paper with a pen that I bought with nine others for a total cost of $1.19 for the 10.

Suppose the government, shocked by Reynolds’ profits, had insisted on recapturing all of his profits above a return of say 6 per cent on capital and made this a universal rule for the industry. Or suppose that Reynolds’ work­ers had insisted on their wages being increased until his profits were brought down to normal. In either case, the price of ball-point pens might well be still $12.95. But because the abnormally high profits were permitted to serve as a signal to other producers, the results were as we have described them above.

A Vital Set of Signals

The above normal profits then are not "too high" in any value sense, nor are the below normal profits "too low." They are sim­ply signals and very, very impor­tant signals as well. In fact, the efficiency of the economy is com­pletely dependent upon their not being silenced or modified.

Nor is this signal system costly to the consumer it serves. Ab­normally high profits in some areas tend to be balanced by be­low normal profits in other areas and the net cost to the consumer is minimal.

If the consumer insists on re­capturing the excess profits, surely he is compelled by logic and con­science to indemnify those who are getting below normal profits and the net gain would be of no immediate significance. The price of doing so, though, would be the destruction of the combined sig­nal and incentive system of the free market—and hence his hope for a free and prosperous society.

In the same way, the worker who would demand that wages be tied to profits, that the employer share his excess profits with him, should be compelled by logic and conscience then to take wage cuts whenever his firm is making be­low average profits. Thus pre­sented, few workers would have much enthusiasm for the arrange­ment.

In sum, then, we gain little in­sight into what has happened to profits by asking if some firms are making profits above or below the average. Such deviations from the average are a normal and indis­pensable part of the functioning of the competitive market econ­omy.

The Concept of Market Structure

We seem now to have thrown out all meaningful ways of evalu­ating profits, of determining what has happened to profits. Perhaps we should give up in despair and turn our attention to some other problem.

Fortunately, there still remain certain indirect approaches to the problem that do have meaning. Let me go back to a phrase I have used several times, "the competi­tive market." It is literally true that profits never can be said to be too high or too low in a com­petitive market. In such a market, forces are always at work to bring profits back to the normal level and the net cost to the consumer is minimal.

But what if the markets in which the firms deal are not com­petitive? What then of profits?

If a given firm has a monopoly of its market, it may be able to make above-normal profits and to make them indefinitely. The sig­nal is going out, but the other firms are prevented by the monop­oly power of this one firm from answering the signal. Under these circumstances it is quite meaning­ful and realistic to say that profits are "too high."

Again, if the firm is selling in a competitive market, but buying its resources (for example, its la­bor services) from units that not competing, it may suffer from a cost squeeze on profits that will cause those profits to be persist­ently below normal. In the short run, the owners of the firm will suffer, and in the long run, the consumer will suffer as firms will get out of the industry in response to a basically false or distorted below-normal profit signal. Here again it is quite meaningful and realistic to say that profits are "too low."

Our search then must take us to the markets of this country, to ask whether product and resource markets are less or more competi­tive than they once were or than they could or should be.

Product Markets

Let us begin with the selling side, with product markets. It is commonly assumed that American business was once small in size and competitive, but that it is now large in size and monopolistic.

This is a complex subject which cannot be explored fully in lim­ited space. However, here are my views in brief form.

(1) I believe that it can be demonstrated that product mar­kets in America are more com­petitive today than they have ever been. My reasoning is that, though firms have grown in size, markets have grown even more rapidly. The absolute size of the actual firm is unimportant. What is im­portant is its size relative to the industry or market in which it operates.

Improvements in transportation and communication and the devel­opment of substitutes for almost any and every kind of product have so widened markets that neither A & P nor U. S. Steel has as much real market power as did the small town grocery store and the local iron foundry a century ago!

(2) I believe that such instances of monopoly as do arise tend to be rather quickly erased by the dy­namic changes in the economy.

(3) I believe that almost all in­stances of persistent monopoly power as do exist can be attrib­uted to positive protection of that power by government. The protec­tion takes such forms as price sup­ports in agriculture, tariffs, fair trade laws, special franchises and licenses, subsidies, and so on.

(4) I believe that the unhamp­ered market naturally tends to be a competitive market. Monopoly is not only unnatural, but can be maintained only with the positive support of government.’

If what I have written above is true, then we can add that profits are not generally "too high" in the American economy, except in those cases where the government is giving direct or indirect sup­port to monopoly power. (Profits can be "too high" even if they are in fact losses! Thus, if the gov­ernment is subsidizing or other­wise aiding a declining industry, losses will be less than in a free market. Thus, returns to the firms involved are "too high" in that they do not accurately reflect the true signal being sent out by con­sumers. Excess resources will be held in the industry long after the consumer has ordered them out! A case in point would be agricul­ture.)

Resource Markets

We turn now to the buying side of the markets in which firms op­erate: to the resource markets. Are these markets less or more competitive than they used to be, or than they can or should be?

This too is a complex question, and again I can do no more than summarize my argument.

(1) I believe that resource mar­kets also tend to be competitive in the absence of government in­tervention. Improved transporta­tion and communication have ex­panded alternatives confronting both the buyer and the seller of most resources, including labor.

(2) However, governments have been particularly active in labor markets in the last 30 years andhave done much to force the em­ployer to hire his labor in non­competitive markets. Governments have done this through direct set­ting of wages, hours, and working conditions and by encouraging, protecting, and giving special priv­ileges to trade unions.

(3) I believe that the effect of this has been to make of the trade union a government-sponsored in­strument for distorting the work­ings of the market. It has resulted in a never-ending cost squeeze on profits in large segments of the American economy.

If what I have said is true, then it follows that what has happened to profits is that they tend to be "too low" in those segments of the American economy most influenced by trade unionism and by wage legislation. Thus the high profit signal is somewhat muffled and resources may not be entering the industry at the rate consumers are ordering them to!

The Impact of Taxes

This tendency is reinforced by the taxing process. Both the fact and the form of profits taxes tend to reduce the effectiveness of the signal system. The effect is one-sided in that profitable industries have their returns taxed by the government, but unprofitable in­dustries do not receive subsidies—nor should they. Permission to do some spreading of losses does not help firms in industries that are expanding and generally profitable, year after year.

Moreover, the unrealistic han­dling of depreciation leads to per­sistent overstating and hence over­taxing of business earnings.

Summary

I have argued that most of the usual ways of evaluating profits are meaningless. I have suggested that profits best can be examined indirectly, by weighing them in the context of the markets in which firms buy and sell. 1 have expressed my belief that the great­est distortion in those markets in America today is in the labor areas, and that, as a consequence of this distortion and of other factors, profits tend to be "too low" in large segments of Ameri­can industry.

I would add that this fact goes a long way to explain the persist­ence of unemployment in an ap­parently prosperous nation. The general business climate created by government interventions, par­ticularly in the labor markets, is not one that creates buoyancy and optimism in the business world. Thus, the economy tends to sag and adjustments are not quickly or easily made. More directly, un­employment tends to be concen­trated in those industries and those areas most influenced by ag­gressive union action in the last 30 years.

If these "too low" profits per­sist, the economy is in danger of being moved even further from the free market ideal. The appar­ent failure or refusal of private enterprise to "do the job" will lead Americans to demand more and more government intervention (witness the demand for deficit spending to "get the country go­ing.")

The solution lies not in raising profits by granting special favors to business (as is so often sug­gested) but in reducing or elim­inating the special handicaps business has faced in its labor markets and in other ways during recent decades.

If this is not done, we are in danger of losing our free econo­my; and when economic freedom is lost, all other freedoms must follow, sooner or later.

***

Ideas on Liberty

John Chamberlain

Profits are, in effect, not added into price but taken out of the cost.

THE FREEMAN

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CURRENT ISSUE

December 2014

Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.